Posts Tagged 'George Selgin'

Supply Shocks and the Summer of our Inflation Discontent

This post started out as a short Twitter thread discussing the role of supply shocks in our current burst of inflation. The thread was triggered by Skanda Aramanth’s tweet arguing that, within a traditional aggregate-demand/aggregate-supply framework, a negative supply shock would have an effect sufficiently inflationary to cause the rate of NGDP growth to rise even with an unchanged monetary policy if the aggregate-demand curve is highly inelastic.

Skanda received some pushback on his contention from those, e.g., George Selgin, who dismissed the assumption of an inelastic aggregate demand as an implausible explanation of recent experience.

Here are the tweets by Skanda and George.

Without weighing in on the plausibility of the inelastic aggregate demand curve assumption, not being very enamored of the aggregate demand/aggregate supply paradigm, which strikes me as a mishmash of inconsistent partial-equilibrium and general-equilibrium reasoning based on a static model with inflationary expectations uneasily attached, I offered the following alternative account of our recent inflationary experience.

There were two supply shocks. The first was the pandemic, in 2020-21. That was followed in late 2021 by the prelude to Putin’s war which sent oil prices up from $50/barrel in early 2021 to nearly $100/barrel by the end of 2021.

The first supply shock required income support for basic consumption during the pandemic resulting in a buildup of purchasing power in the form of cash balances or other liquid assets for which there was no immediate outlet during the pandemic.

The buildup of unused purchasing power implied that the end of the pandemic would involve a positive but transitory shock to aggregate demand when the economy (production and consumption patterns) returned to normal as the limitations imposed by the pandemic began to ease.

The alternative to allowing the positive but transitory shock to aggregate demand would have been to adopt a restrictive policy as the pandemic was easing, which made neither economic or political sense. The optimal policy was to accept temporary inflation during the recovery, rather than impose a deflationary policy to suppress transitory inflation.

The transitory inflation was exacerbated by various supply bottlenecks and shortages of workers and other productive resources, which were reflected the difficulties of ramping up production quickly after lengthy production shutdowns or curtailments during the height of the pandemic.

These transitory difficulties would have likely worked themselves out by the end of 2021 had it not been for the second supply shock associated with the months long buildup to Putin’s war which was anticipated for months before it actually started in February 2022,  causing a second increase in inflation just when the first burst of inflation in the second half of 2021 would have tapered off.

No doubt, it would have been better for the Fed to have started tightening earlier so keep the NGDP from increasing so rapidly at the end of 2021 and the start of 2022, but the scare talk about unanchoring inflation expectations has been overdone.

Financial markets clearly reflect expectations that the Fed is going to rein in aggregate demand so that the excess growth in NGDP in 2021 will have little long-term effect. Even with the continuing potential that Putin’s War will cause further supply disruptions with short-term inflationary effects, the current and likely future conditions seem far better than result than that would have produced by the Volcker 2.0 policy for which Larry Summers et al. are still pining.

Hayek, Free Banking and Tax Payments

Among the many interesting comments on my previous post about free banking was one by Philippe which provoked an extended (and perhaps still ongoing) exchange between Philippe and George Selgin. Referring to this assertion of mine,

if free banking were adopted without abolishing existing fiat currencies and legal tender laws, there is almost no chance that, as Hayek argued, new privately established monetary units would arise to displace the existing fiat currencies

Philippe made the following comment:

In “The Denationalization of Money” Hayek argued that you should be able to pay taxes with privately-issued currencies. However, this would in effect turn those ‘private currencies into’ de facto state currencies, or forms of government ‘fiat money’. For some reason Hayek chose to ignore this massive contradiction in his argument. Essentially, what he was actually arguing was that private corporations should be granted special state powers, i.e. the power to issue money backed by the state’s legal powers of taxation.

I thought that this was a very insightful observation by Philippe, though its significance for me may be somewhat different from its significance for Philippe. In my criticisms of Hayek’s free-banking position – I call it a free-banking position even though free banking may be a misnomer inasmuch as Hayek advocated banks’ creating new currency units not just allowing banks freedom to create a complete menu of liabilities denominated in existing currency units – my argument was that newly created currency units would be worthless unless the banks made them convertible into some outside asset not under their control. Or in Nick Rowe’s helpful terminology, Hayek advocated free-alpha-banking, while conventional free bankers advocate free-beta-banking. The reasoning behind my argument is that the value of a pure medium of exchange depends entirely on its expected value in exchange, so if a currency unit is not defined in terms of a commodity providing a real, valuable, service apart from being used as money, people will eventually realize that its value must go to zero. Any positive value that it may temporarily have is just a bubble, and, like every bubble, it will burst.

However, unlike the private issuer of a currency unit, a sovereign issuer can impart a real value to a fiat currency by making the currency acceptable for discharging tax liabilities, creating a real demand for the currency distinct from its use as a medium of exchange. Using this argument, I have suggested that bitcoins are a bubble, though it is possible that are some techie reasons that I don’t understand why bitcoins could provide real services that would allow them retain a positive value. At any rate, the point made by Philippe — that if governments were to accept newly created private currency units in payment of taxes – they could retain their value just as fiat currencies issued by governments do – is a point that had escaped me in my criticisms of Hayek. So, well done, Philippe.

However, Philippe seems to carry this valid point a bit too far, accusing Hayek of a massive contradiction in arguing that private corporations be granted special state powers. The problem with that argument is that it begs the question what is special about money that confers the sole power to issue money to the state. I actually once wrote a paper trying to answer that question (once again relying on an argument that I heard from Earl Thompson) published in a volume called Money and the Nation State. I summarized the argument in chapter 2 of Free Banking and Monetary Reform.

The short answer is that currency debasement may be necessary as a means of emergency taxation when a sovereign is faced with a hostile military force threatening its survival. To profitably debase a currency, you have to be the monopoly supplier. Ergo, sovereigns that monopolize the mint or the supply of currency have a better chance of surviving than sovereigns that don’t. Hayek was a staunch anti-communist, cold warrior, so the defense argument, at least on some level, would have appealed to him. But otherwise, it’s not clear to me why Hayek could not have said that, apart from certain national-defense functions, there really are no government services that may not be provided by private enterprise. After all, we do allow various services that were once exclusively provided by the government to be provided by private enterprise. I don’t say that this is always a good thing, but it doesn’t seem to me inherently unreasonable to believe that the burden of proof is on the one claiming that the state has an exclusive right to discharge a particular service, not on the one who questions that such an exclusive right exists.

Having said that, I will also say that it also seems perfectly reasonable for a government to say that a tax obligation that it legitimately imposes – I freely admit that I am now begging the question where this legitimate power comes from, but only libertarian fanatics dispute that power – can only be discharged in terms of a currency unit that the government itself specifies. And implicitly or explicitly, George Selgin and other free bankers — i.e., free-beta-bankers — seem to be perfectly OK with the government specifying the currency unit in terms of which tax obligations may be discharged. In other words, the government may impose a tax obligation on me that is specified in dollar terms. To discharge it, I have no choice but to pay the government the requisite number of dollars, either delivering the government’s own currency or delivering a private (beta-bank) money denominated in dollar terms.

The peculiarity in Hayek’s argument is that he was proposing that governments impose a tax liability in, say, dollar terms, and then accept payment in some other currency unit without specifying any method by which an obligation specified in dollars would be discharged in terms of another currency unit. Any creditor is free to specify at the time an obligation is created the terms on which the debt will be discharged (subject of course to legal tender laws, but for purposes of this discussion I am ignoring legal tender laws which are not the same as tax acceptance). The government is not just any creditor, but there doesn’t seem to me to be any compelling reason why a government should not be entitled to say we have created this obligation in terms of dollars and it must be discharged in terms of dollars. And, if I am right in asserting that acceptability in payment of taxes is a necessary condition for an inconvertible fiat money to retain value, there does seem to be something funny about Hayek’s argument for the creation of private fiat moneys, even if it is not a flat-out contradiction as Philippe claims.

What is funny is the degree to which the viability of a Hayekian private fiat currency is dependent on its being accepted by the state as payment for taxes. Moreover, Hayek’s argument was that there would be a discovery process in which many competing currencies would vie for acceptance with the market eventually choosing one or a few currency units as somehow being the most desirable. Hayek thought that the currency unit with the most stable value would eventually capture the largest market share. There are lots of problems with the argument, especially that it ignores the network effects that tend to produce an entrenched monopoly, and the extreme path dependence of such outcomes, but on a practical level, it seems almost unimaginable that a government would, or could, allow any number of distinct competing currency units to be simultaneously acceptable in payment of taxes.

I do not mean to be overly critical of Hayek, for whom I always have had the greatest admiration, but he had an unfortunate tendency to get carried away with certain utopian ideas and proposals, for example his idea of separating the law-making power from the governing function of parliaments into two distinct bodies, going so far as to propose a method for selecting members of the law-making body under which people at the age of 35 would each year elect a number of their contemporaries to serve a 15-year term in the law-making body, the law-making body being composed entirely of people between the ages of 35 and 50. He presents the idea in volume 3 of Law, Legislation and Liberty, a wonderful book of great philosophical depth and erudition. But it is amazing that Hayek felt that such an idea could ever be implemented. I don’t like to think so, but it occurs to me that his toleration for certain dictators might have had something to do with his imagining that they could be persuaded to implement his ideas for political and constitutional reform. His Denationalization of Money was a similar flight of fancy, based on some profound insights, but used as the basis for practical proposals that were fantastically unrealistic.


What Is Free Banking All About?

I notice that there has been a bit of a dustup lately about free banking, triggered by two posts by Izabella Kaminska, first on FTAlphaville followed by another on her own blog. I don’t want to get too deeply into the specifics of Kaminska’s posts, save to correct a couple of factual misstatements and conceptual misunderstandings (see below). At any rate, George Selgin has a detailed reply to Kaminska’s errors with which I mostly agree, and Scott Sumner has scolded her for not distinguishing between sensible free bankers, e.g., Larry White, George Selgin, Kevin Dowd, and Bill Woolsey, and the anti-Fed, gold-bug nutcases who, following in the footsteps of Ron Paul, have adopted free banking as a slogan with which to pursue their anti-Fed crusade.

Now it just so happens that, as some readers may know, I wrote a book about free banking, which I began writing almost 30 years ago. The point of the book was not to call for a revolutionary change in our monetary system, but to show that financial innovations and market forces were causing our modern monetary system to evolve into something like the theoretical model of a free banking system that had been worked out in a general sort of way by some classical monetary theorists, starting with Adam Smith, who believed that a system of private banks operating under a gold standard would supply as much money as, but no more money than, the public wanted to hold. In other words, the quantity of money produced by a system of competing banks, operating under convertibility, could be left to take care of itself, with no centralized quantitative control over either the quantity of bank liabilities or the amount of reserves held by the banking system.

So I especially liked the following comment by J. V. Dubois to Scott’s post

[M]y thing against free banking is that we actually already have it. We already have private banks issuing their own monies directly used for transactions – they are called bank accounts and debit/credit cards. There are countries like Sweden where there are now shops that do not accept physical cash (only bank monies) – a policy actively promoted government, if you can believe it.

There are now even financial products like Xapo Debit Card that automatically converts all payments received on your account into non-monetary assets (with Xapo it is bitcoins) and back into monies when you use the card for payment. There is a very healthy international bank money market so no matter what money you personally use, you can travel all around the world and pay comfortably without ever seeing or touching official local government currency.

In opposition to the Smithian school of thought, there was the view of Smith’s close friend David Hume, who famously articulated what became known as the Price-Specie-Flow Mechanism, a mechanism that Smith wisely omitted from his discussion of international monetary adjustment in the Wealth of Nations, despite having relied on PSFM with due acknowledgment of Hume, in his Lectures on Jurisprudence. In contrast to Smith’s belief that there is a market mechanism limiting the competitive issue of convertible bank liabilities (notes and deposits) to the amount demanded by the public, Hume argued that banks were inherently predisposed to overissue their liabilities, the liabilities being issuable at almost no cost, so that private banks, seeking to profit from the divergence between the face value of their liabilities and the cost of issuing them, were veritable engines of inflation.

These two opposing views of banks later morphed into what became known almost 70 years later as the Banking and Currency Schools. Taking the Humean position, the Currency School argued that without quantitative control over the quantity of banknotes issued, the banking system would inevitably issue an excess of banknotes, causing overtrading, speculation, inflation, a drain on the gold reserves of the banking system, culminating in financial crises. To prevent recurring financial crises, the Currency School proposed a legal limit on the total quantity of banknotes beyond which limit, additional banknotes could be only be issued (by the Bank of England) in exchange for an equivalent amount of gold at the legal gold parity. Taking the Smithian position, the Banking School argued that there were market mechanisms by which any excess liabilities created by the banking system would automatically be returned to the banking system — the law of reflux. Thus, as long as convertibility obtained (i.e., the bank notes were exchangeable for gold at the legal gold parity), any overissue would be self-correcting, so that a legal limit on the quantity of banknotes was, at best, superfluous, and, at worst, would itself trigger a financial crisis.

As it turned out, the legal limit on the quantity of banknotes proposed by the Currency School was enacted in the Bank Charter Act of 1844, and, just as the Banking School predicted, led to a financial crisis in 1847, when, as soon as the total quantity of banknotes approached the legal limit, a sudden precautionary demand for banknotes led to a financial panic that was subdued only after the government announced that the Bank of England would incur no legal liability for issuing banknotes beyond the legal limit. Similar financial panics ensued in 1857 and 1866, and they were also subdued by suspending the relevant statutory limits on the quantity of banknotes. There were no further financial crises in Great Britain in the nineteenth century (except possibly for a minicrisis in 1890), because bank deposits increasingly displaced banknotes as the preferred medium of exchange, the quantity of bank deposits being subject to no statutory limit, and because the market anticipated that, in a crisis, the statutory limit on the quantity of banknotes would be suspended, so that a sudden precautionary demand for banknotes never materialized in the first place.

Let me pause here to comment on the factual and conceptual misunderstandings in Kaminska’s first post. Discussing the role of the Bank of England in the British monetary system in the first half of the nineteenth century, she writes:

But with great money-issuance power comes great responsibility, and more specifically the great temptation to abuse that power via the means of imprudent money-printing. This fate befell the BoE — as it does most banks — not helped by the fact that the BoE still had to compete with a whole bunch of private banks who were just as keen as it to issue money to an equally imprudent degree.

And so it was that by the 1840s — and a number of Napoleonic Wars later — a terrible inflation had begun to grip the land.

So Kaminska seems to have fallen for the Humean notion that banks are inherently predisposed to overissue and, without some quantitative restraint on their issue of liabilities, are engines of inflation. But, as the law of reflux teaches us, this is not true, especially when banks, as they inevitably must, make their liabilities convertible on demand into some outside asset whose supply is not under their control. After 1821, the gold standard having been officially restored in England, the outside asset was gold. So what was happening to the British price level after 1821 was determined not by the actions of the banking system (at least to a first approximation), but by the value of gold which was determined internationally. That’s the conceptual misunderstanding that I want to correct.

Now for the factual misunderstanding. The chart below shows the British Retail Price Index between 1825 and 1850. The British price level was clearly falling for most of the period. After falling steadily from 1825 to about 1835, the price level rebounded till 1839, but it prices again started to fall reaching a low point in 1844, before starting another brief rebound and rising sharply in 1847 until the panic when prices again started falling rapidly.


From a historical perspective, the outcome of the implicit Smith-Hume disagreement, which developed into the explicit dispute over the Bank Charter Act of 1844 between the Banking and Currency Schools, was highly unsatisfactory. Not only was the dysfunctional Bank Charter Act enacted, but the orthodox view of how the gold standard operates was defined by the Humean price-specie-flow mechanism and the Humean fallacy that banks are engines of inflation, which made it appear that, for the gold standard to function, the quantity of money had to be tied rigidly to the gold reserve, thereby placing the burden of adjustment primarily on countries losing gold, so that inflationary excesses would be avoided. (Fortunately, for the world economy, gold supplies increased fairly rapidly during the nineteenth century, the spread of the gold standard meant that the monetary demand for gold was increasing faster than the supply of gold, causing gold to appreciate for most of the nineteenth century.)

When I set out to write my book on free banking, my intention was to clear up the historical misunderstandings, largely attributable to David Hume, surrounding the operation of the gold standard and the behavior of competitive banks. In contrast to the Humean view that banks are inherently inflationary — a view endorsed by quantity theorists of all stripes and enshrined in the money-multiplier analysis found in every economics textbook — that the price level would go to infinity if banks were not constrained by a legal reserve requirement on their creation of liabilities, there was an alternative view that the creation of liabilities by the banking system is characterized by the same sort of revenue and cost considerations governing other profit-making enterprises, and that the equilibrium of a private banking system is not that value of money is driven down to zero, as Milton Friedman, for example, claimed in his Program for Monetary Stability.

The modern discovery (or rediscovery) that banks are not inherently disposed to debase their liabilities was made by James Tobin in his classic paper “Commercial Banks and Creators of Money.” Tobin’s analysis was extended by others (notably Ben Klein, Earl Thompson, and Fischer Black) to show that the standard arguments for imposing quantitative limits on the creation of bank liabilities were unfounded, because, even with no legal constraints, there are economic forces limiting their creation of liabilities. A few years after these contributions, F. A. Hayek also figured out that there are competitive forces constraining the creation of liabilities by the banking system. He further developed the idea in a short book Denationalization of Money which did much to raise the profile of the idea of free banking, at least in some circles.

If there is an economic constraint on the creation of bank liabilities, and if, accordingly, the creation of bank liabilities was responsive to the demands of individuals to hold those liabilities, the Friedman/Monetarist idea that the goal of monetary policy should be to manage the total quantity of bank liabilities so that it would grow continuously at a fixed rate was really dumb. It was tried unsuccessfully by Paul Volcker in the early 1980s, in his struggle to bring inflation under control. It failed for precisely the reason that the Bank Charter Act had to be suspended periodically in the nineteenth century: the quantitative limit on the growth of the money supply itself triggered a precautionary demand to hold money that led to a financial crisis. In order to avoid a financial crisis, the Volcker Fed constantly allowed the monetary aggregates to exceed their growth targets, but until Volcker announced in the summer of 1982 that the Fed would stop paying attention to the aggregates, the economy was teetering on the verge of a financial crisis, undergoing the deepest recession since the Great Depression. After the threat of a Friedman/Monetarist financial crisis was lifted, the US economy almost immediately began one of the fastest expansions of the post-war period.

Nevertheless, for years afterwards, Friedman and his fellow Monetarists kept warning that rapid growth of the monetary aggregates meant that the double-digit inflation of the late 1970s and early 1980s would soon return. So one of my aims in my book was to use free-banking theory – the idea that there are economic forces constraining the issue of bank liabilities and that banks are not inherently engines of inflation – to refute the Monetarist notion that the key to economic stability is to make the money stock grow at a constant 3% annual rate of growth.

Another goal was to explain that competitive banks necessarily have to select some outside asset into which to make their liabilities convertible. Otherwise those liabilities would have no value, or at least so I argued, and still believe. The existence of what we now call network effects forces banks to converge on whatever assets are already serving as money in whatever geographic location they are trying to draw customers from. Thus, free banking is entirely consistent with an already existing fiat currency, so that there is no necessary link between free banking and a gold (or other commodity) standard. Moreover, if free banking were adopted without abolishing existing fiat currencies and legal tender laws, there is almost no chance that, as Hayek argued, new privately established monetary units would arise to displace the existing fiat currencies.

My final goal was to suggest a new way of conducting monetary policy that would enhance the stability of a free banking system, proposing a monetary regime that would ensure the optimum behavior of prices over time. When I wrote the book, I had been convinced by Earl Thompson that the optimum behavior of the price level over time would be achieved if an index of nominal wages was stabilized. He proposed accomplishing this objective by way of indirect convertibility of the dollar into an index of nominal wages by way of a modified form of Irving Fisher’s compensated dollar plan. I won’t discuss how or why that goal could be achieved, but I am no longer convinced of the optimality of stabilizing an index of nominal wages. So I am now more inclined toward nominal GDP level targeting as a monetary policy regime than the system I proposed in my book.

But let me come back to the point that I think J. V. Dubois was getting at in his comment. Historically, idea of free banking meant that private banks should be allowed to issue bank notes of their own (with the issuing bank clearly identified) without unreasonable regulations, restrictions or burdens not generally applied to other institutions. During the period when private banknotes were widely circulating, banknotes were a more prevalent form of money than bank deposits. So in the 21st century, the right of banks to issue hand to hand circulating banknotes is hardly a crucial issue for monetary policy. What really matters is the overall legal and regulatory framework under which banks operate.

The term “free banking” does very little to shed light on most of these issues. For example, what kind of functions should banks perform? Should commercial banks also engage in investment banking? Should commercial bank liabilities be ensured by the government, and if so under what terms, and up to what limits? There are just a couple of issues; there are many others. And they aren’t necessarily easily resolved by invoking the free-banking slogan. When I was writing, I meant by “free banking” a system in which the market determined the total quantity of bank liabilities. I am still willing to use “free banking” in that sense, but there are all kinds of issues concerning the asset side of bank balance sheets that also need to be addressed, and I don’t find it helpful to use the term free banking to address those issues.

About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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